I find that, when discussing The Shadow Inventory, almost all real estate specialists, lawyers, regulators and many financial analysts can’t tie one very significant cause into the conversation.
The very significant cause that is missed is a rational explanation of why banks and other mortgage investors are so reluctant to liquidate (or renegotiate) bad investments.
Why do they hold significant amounts of mortgage investments which have little hope of being profitable (over the long term)? When a mortgage is in serious default, why don’t mortgage investors accept a ‘short sale’ - and why do they allow a property to go into the potentially higher loss alternative of foreclosure?
I believe the key to understanding why mortgage investors appear to be behaving irrationally, is to understand the implications of the delay in the implementation of Financial Accounting Standard #157 (mark-to-market accounting).(1)
To understand the implications of the delay in the implementation of FAS #157 read an article from the Wall Street Journal titled, Congress Helped Banks Defang Key Rule By Susan Pulliam & Tom McGinty | pub. 6/3/2009.(2)
Then watch Georgetown University Law Professor, Adam Levitin’s Congressional testimony titled, Federal Regulators Don’t Want to Know . . . (3)
The point that I believe most commenters miss:
The postponement of the implementation of mark-to-market accounting (FAS 157) gives banks and other mortgage (product) investors the opportunity to delay recognition of their market losses until legal ownership of the property changes (foreclosure). Thus, for the investor, the hoped for offset of losses against future revenue is 'the gating factor’ for the liquidation of the shadow inventory.
Most mortgage investors are institutions. These institutions want to delay the recognition of, and the reporting reporting of, any losses to their investors - and to their regulators - for as long as possible.
As Professor Levitin explains in his Congressional testimony, these institutional investors hope to offset losses against income (fees and penalty revenue) over the next decade.
So, the shadow inventory seems to be a consequence of the rational ‘work-out’ in a world in which institutions can carry (and report) highly depreciated assets at (fantasy) origination value.
P.S. I believe in creative destruction.(4)
1. See Wikipedia Mark-to-Market accounting scroll to, Effect on subprime crisis and Emergency Economic Stabilization Act of 2008, at: http://en.wikipedia.org/wiki/Mark-to-market_accounting
2. Congress Helped Banks Defang Key Rule By Susan Pulliam & Tom McGinty | pub. 6/3/2009. http://online.wsj.com/article/SB124396078596677535.html
3. Georgetown University Law Professor, Adam Levitin’s Congressional testimony titled, Federal Regulators Don’t Want to Know . . . at: http://youtu.be/ibgdgl0PoBw
4. Creative Destruction (Shumpeter) see: http://en.wikipedia.org/wiki/Creative_destruction
End Note: Even some fairly sophisticated observers can’t put the delay in the implementation of FAS 157 into its proper perspective. Why do mortgage investors prefer foreclosure over a short sale? Watch Congressman Bobby Scott (D-VA) question a panel of mortgage professionals asking, ‘Are there things in accounting principals that we need to change to get everybody to do what’s in everybody's best interests?’at:
Then listen to Thomas Cox, of Main Attorney’s Saving Homes Project, answer Rep. Scott. Mr. Cox emphasizes a different point (the conflict of interest created by servicer fee revenue) in The Short Sale Conundrum - Misaligned Incentives of Mortgage Servicers, at: and when James Kowalski, a Florida Trial Attorney for Saving Home Project, gets his turn he moves to The MERS Mess. Mr. Kawolski explains the increase in the shadow inventory as a documentation problem rather than an accounting problem, at: